If you run a small business, you realize early that money can be scarce and you must deploy it wisely. You may want to invest in one or more new projects or expansion ideas but have only limited funds to do so. Capital rationing is the constraint on your spending due to limited funds. The net present value, or NPV, investment appraisal method helps you choose which projects to adopt within your constraints.

Net Present Value

The net present value of an investment is the profit or loss you expect to experience from the investment’s cash flows, expressed in current dollars. The idea behind NPV is that money in your pocket today is worth more than money you might receive in the future, because of the uncertainty factor. In the NPV method, you discount future cash outflows and inflows by an appropriate interest rate to arrive at the current-dollar value. At the very least, you would want to only pursue projects that give a positive NPV.

Capital Rationing

You can raise capital by contributing your own cash to the business, plowing profits back into the company, borrowing money from investors and privately placing common and preferred stock. You will normally have more uses for capital than capital itself, which requires you to ration it. Your ability to raise external capital is the first hurdle in funding projects. You next must budget the capital you have to maximize possible return while minimizing risk of loss.

Cost of Capital

Capital costs money. For debt, the cost is the interest you pay. For stock, it’s the dividend and the price growth that investors demand. You can calculate the weighted average cost of capital to find out the minimum percentage return you need from a project so it pays for the capital you expend on it. By converting NPV to a percentage of the project costs, known as the internal rate of return, you can eliminate projects that return less than the weighted average cost of capital.

Example

Suppose a project requires a $100,000 expenditure up front but has cash flows over the following four years that bring in $50,000, $40,000, $30,000 and $20,000, respectively. You are investing $100,000 today to receive $140,000 in future dollars. Your weighted average cost of capital is 3.125 percent, so you discount your future cash flows by that percentage per year to calculate NPV, which works out to $31,136. You calculate the internal rate of return, which is a healthy 17.8 percent. If you have no other projects that return more, you would ration a substantial portion of your investment capital for this project, as it provides a positive NPV and a return above that of other projects and well above your cost of capital.